Paying for college is a source of confusion and anxiety for parents and students alike. Sticker shock is common when shopping for tuition rates among selected schools. Add the price of books, housing, and meals on top of tuition, and the total amount due is likely to increase at least 50%.
In 2018, the average tuition rate for a public school was $21,370, while private schools cost an average of $48,510 each year. To pay for this and other related costs (books, etc.), students took out an average of $29,800 in loans. This amount varies from public to private students, but it’s a large number, nonetheless.
But what options do we have? This alone is confusing. Are students and parents required to take out loans to fund education? Are there other options? Not all options are the same, and each comes with its own set of pros and cons that should be considered when choosing the best way to foot the bill. The most common options (in order of probable preference) are:
Federal Subsidized Loans
Federal Unsubsidized Loans
“Parent Plus” Loans
While a recent survey showed that 69% of college students take out student loans to pay for school, this means that more than 30% of college expenses are funded by scholarships, grants, and cash.
In many cases, this cash comes from savings plans that have been designed to help parents and students prepare for college expenses. One of the most common college savings plans is a 529 plan, a savings fund that allows savers to contribute cash to an account, often when a future student is a young child. The cash is allowed to be invested, grown, and then withdrawn tax-free when the funds are needed to pay for school. Not only are the plans designed to offer some federal tax savings, but some states (like Illinois) offer state tax deductions for contributions made over the years.
The most obvious upside to using cash to fund college? Little to no debt. No interest payments. No principal payments. Peace of mind. No need to worry about qualifying for aid, running your credit for the best interest rates, or graduating with massive student loan debt. Overall, this equates to far less stress and confusion.
If funds from a college savings plan (like the 529 plan) aren’t available but students (and/or their parents) have a reserve of cash available for college, loans might still make the most sense. Why? Compounding interest.
Most federal student loans come with fairly competitive interest rates, making them attractive for people who can find a better place to invest that cash (like a retirement savings account). For example, if the federal student loan interest rate is 4%, but an individual could earn 7-10% in a retirement savings plan, it may make more sense to invest that cash in retirement rather than college. While this leaves students/parents with a loan balance upon graduation, it leaves them, in theory, with a greater nest egg.
Striking the right balance between cash vs. loans vs. other investments is a great conversation for your financial advisor.
Federal Subsidized Loans
This is the most common and likely the wisest loan option. Interest rates are usually lower than private loans, the repayment terms are often more flexible, and they don’t require repayment until after you graduate.
As of this publication, undergraduate students can borrow anywhere from $3,500 - 5,500 per year in subsidized loans, and the interest rate is 4.53%.
One of the biggest advantages to subsidized loans is that they don’t accrue any interest while you’re in school or within the deferment period after you graduate. That means that you can take your time repaying or prioritize payments while in school if you have other loan types. Interest rates for subsidized loans are also fixed, which means you won’t experience any changes in payments if the government-mandated interest rate on loans shifts one way or another.
Subsidized loans are particularly beneficial for young students because there are no minimum credit scores required to qualify for funds. Since many students have yet to establish adequate credit ratings, these loans are an approachable option.
While Direct Subsidized Loans are the safest loans in many ways, they’re limited by what the government determines a student needs in a given year. With the inclusion of parental income, regardless of their actual contribution to a student’s finances, the awarded dollar amount can be significantly less than what a student actually requires to pay for school.
The amount a student receives is also limited by a general cap. For example, a freshman is only eligible for $3,500 in subsidized student loans even if the government determines that they meet all need-based requirements. Over the years, a senior in college will still only be eligible for a maximum of $5,500 in subsidized loans.
Federal Unsubsidized Loans
Direct unsubsidized loans are also Federal Student Loans awarded to students on a yearly basis. Like subsidized loans, students must complete the FAFSA each year in order to be eligible for direct unsubsidized loans.
As of this publication, undergraduate students can borrow anywhere from $5,500 - 7,500 per year in unsubsidized loans, and the interest rate is 4.53%.
Unsubsidized loans aren’t based on financial need the same way subsidized loans are. This can be great news for a college student whose parents’ income disqualifies them from subsidized loans, especially in cases where a student isn’t receiving financial support from their parents. Eligibility and the total amount awarded each year for an unsubsidized loan is determined by the cost of schooling and presence of additional financial aid.
Unsubsidized loans also have a higher award cap, meaning that you can get more aid each year. A freshman can potentially receive up to $5,500 in unsubsidized loans, while an upper-classman can apply for $7,500.
Interest accrues while you’re in school, meaning that, by the time you graduate, some interest will already be due (unlike direct subsidized loans, on which interest is paid by the government while you’re in school). To avoid adding interest to your loan balance while in school, you could make interest-only payments as the interest accrues, but this isn’t always a realistic option for students.
Parent Plus Loans
When a student has maxed out their available subsidized and unsubsidized loans, parents can apply for what is aptly called a Parent Plus Loan. These loans are still in the Federal Loan category and can be a great option.
Unlike other federal student loan options where the student is responsible for repayment, the parent is the borrower for Parent Plus Loans making them responsible for paying monthly repayments and interest.
As of this publication, borrowing amounts are not generally capped (there is some fine print), and the interest rate is 7.08%.
Parent Plus loans are an excellent option for parents who want to make up the difference between cost and available financial aid. With no cap, parents can borrow up to the total amount needed to cover their child’s cost of attending college after subtracting other loans and financial awards.
The interest rates will also remain fixed over the life of the Parent Plus Loan just as with other federal loan options. That makes planning repayment options much easier. In fact, Parent Plus Loans offer several repayment options including a 10 year plan, a graduated 10 year plan where payments slowly increase, a 25 year plan, and an income-based plan.
Because Parent Plus Loans don’t have a cap on the amount that can be borrowed, applicants must undergo a credit check. If your credit score is less than adequate, you won’t be eligible to receive a loan and the student will need to seek other financial aid options.
If you are approved for a Parent Plus Loan, be prepared for significantly high interest rates and an origination fee. The origination fee is applied to the loan amount when funds are disbursed, adding to the overall amount to which interest rates are applied. Depending on your existing financial responsibilities, it might be worthwhile to seek a private loan with lower interest rates and skip the origination fee.
Parent Plus Loans also require immediate repayment, unlike subsidized and unsubsidized loans that don’t need to be repaid until after graduation. Though it is possible for parents to apply for a deferment while students are still taking classes, repayment terms are expected to kick in as soon as the loan amount is paid to the school.
If you’ve maxed out your federal student aid, you can turn to private loans as a supplement to pay for school. Depending on the amount you qualify for, private loans can allow you to pay for college in full and provide you with flexible repayment terms.
Private student loans are a good option when it comes to saving on interest rates. When applying for private loans, you have the option to compare offers and choose the one with the lowest rate. You can also choose between fixed rate and variable rate loans, allowing you to choose between set payments with slightly higher interest rates or lower interest rates up front with the understanding that rates might change.
Private loans also offer more flexible repayment terms, unlike federal loans that often set up a repayment schedule based on a 10-year loan period. With private loans, you can choose a longer term for your loan and make smaller payments over time. If you pay back your loan faster, you could end up saving money on interest rates in the long run.
Private lenders aren’t willing to take as much risk on student borrowers, which means you’ll need to pass a credit check in order to receive a loan. If you have bad credit or no credit, you might need your parents to co-sign your loan and assume responsibility for your debt. This situation can understandably strain even the best relationships if you fail to meet repayment terms and default on the loan.
If you do qualify for a private loan, make sure to do the research on how variable vs fixed interest rates will affect your repayment plan. You might think you’re getting a better loan if you choose a variable rate for a lower percentage in interest, but end up making much higher payments if and when interest rates rise.
Private lenders are also often unwilling to offer repayment assistance if your financial situation changes or you need to defer payments. If helping you manage your debt doesn’t benefit them, they’re likely to remain inflexible and you could end up getting sent to collections.
When choosing how to pay for college, make sure you look deeper into the opportunity costs associated with cash funding, federal aid, private loans. Examine the role taxes play in each decision. Look into tax credits and deductions, as well as the ways in which interest payments on loans will affect your tax position. Additionally, discuss your college plans with your financial advisor to get their take on the best options given your current financial position. Whatever option you choose, try to generate the greatest return possible on your investment in college.